The investment company industry has grown approximately 100 fold over the last two decades. According to the Investment Company Institute, total assets under management for the industry rose from $55.9 billion at the end of 1978 to $5,525.2 billion at the end of 1998.
As a result of this rapid growth, the industry is now the largest manager of investment funds for US citizens. The number of registered investment funds now exceeds the number of stocks listed on the major exchanges.
The fundamental structure of the industry has not changed during this period of rapid growth. In particular, investment decision making for each fund is still centralized in a management company that runs the fund or in the fund itself. As a result, all investors in a fund share in the same investments and the same investment decision making. Accordingly, investors in a fund cannot expect investment decision making to be tailored to their individual needs, and investment decision making is not under their control.
A new fund management company, StockJungle.com, has just launched a new fund the last week in November 1999 called Community Intelligence Fund, and visitors to the company's Web site can suggest new holdings to the fund's portfolio manager, thus creating what is believed to be a first in the industry—offering investors and mere visitors to the Web site an opportunity to possibly exert a very limited influence on what is otherwise still a centralized, investment decision making of the fund.
The centralized, one-size-fits-all investment decision making of investment funds is not a good fit with the unique investment needs of individual investors. The investment needs of investors are a function of a large number of variables including current age, planned retirement age, tax factors, number and ages of children, expected retirement age, desired retirement income, expected education cost per child, current and expected future income, current wealth, current and expected future savings, desired amount to bequeath to heirs, desired amounts of charitable gifts, risk preference, risk tolerance, investment expertise, time available for managing investments, desire to manage investments and enjoyment derived from managing investments.
Tax factors can be an especially important source of difficulty when investing in present investment funds. When a fund realizes gains, all investors in the fund are taxed on their portion of the gain—whether or not they have actually participated in the gain on which they are being taxed. Taxation of “phantom” gains often occurs when investors purchase shares in a fund with significant unrealized gains. The new investors in the fund pay a price for their shares that includes the unrealized gains. Therefore, when the fund realizes the gains and passes the realized gains through to current investors the new investors must pay tax on “phantom gains”—gains that the fund realized but in which they did not participate because they paid the appreciated price rather than the lower original cost when they purchased their shares in the fund.
Another tax problem with the centralized investment management of present investment funds is that the decision on the amount and timing for the realization of gains is out of the control of the investors in the fund. As a result, investments in funds that are held in taxable accounts can be tax-inefficient for investors. In response to this problem, funds have been formed that attempt to maximize tax efficiency by minimizing the amount of gains that are realized. However, funds that minimize the realization of gains build up large amounts of unrealized gains, creating the potential of large amounts of “phantom” capital gains for future investors. Also, investors are still unable to control the timing of the realization of gains, which can be very important in tax management.
In addition, any capital losses realized by present funds cannot be passed through to investors, they must be carried forward within the fund and applied against future capital gains realized by the funds. As a result of this and of the centralized control of investment decision making, investors in funds are largely denied the opportunity to realize losses in order to offset them against gains elsewhere.
Investing directly in stocks, bonds and other investments restores control over investment decision making to individual investors and their investment advisors. This direct control allows investors to invest in a manner consistent with their unique individual investment goals and consistent with their personal tax situation. However, direct investment creates an investment performance and/or investment safety problem that is unavoidable for all but the wealthiest investors—the inability to economically achieve adequate diversification to maintain investment risk at acceptable levels.
The ability of diversification to significantly reduce risk without reducing the return on investment is a centerpiece of modern investment theory. In the absence of adequate diversification investors can minimize the risk of ruin only by limiting investment to the safest investments (e.g., government bonds and government guaranteed certificates of deposit). However, the safest investments have the lowest returns and restricting investments to the safest investments significantly reduces investment performance.
The difficulty of maintaining adequate diversification in direct investment is further increased by considering the need to invest current cash flows, both from savings and from investment income, in diversified investments in a timely fashion. Because these current cash flows are (except for investors beginning with very low wealth positions) much smaller than the total portfolio amount, only very small amounts of each investment can be purchased when the cash flows are spread over a diversified selection of investments. Therefore, even relatively wealthy investors may face difficulty in efficiently maintaining adequate diversification of direct investment portfolios.
Investment funds are the vehicle that has allowed virtually all individual investors to efficiently achieve adequate diversification. Investment funds aggregate the investments of large numbers of individual investors, making it possible for individual investors to efficiently invest in a diversified manner. The problem for individual investors is that gaining the ability to efficiently diversify by investing in current investment funds means accepting centralized investment decision making that is only partially consistent with their unique individual investment needs.